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Marvel At The Derivative On Its Derivatives That Credit Suisse Wrote To Itself

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Financial news is very serious business and you should probably fret more than you do about the economy and the banksters and the muppets and the homeowners and so forth. Some things, though, are best viewed as purely aesthetic triumphs, and your reaction should just be an appreciative whistle. This starts slow but stick with it, it gets wonderful:

Our results are impacted by the risk of counterparty defaults and the potential for changes in counterparty credit spreads related to our derivative trading activities. In 1Q12, we entered into the 2011 Partner Asset Facility transaction (PAF2 transaction) to hedge the counterparty credit risk of a referenced portfolio of derivatives and their credit spread volatility. The hedge covers approximately USD 12 billion notional amount of expected positive exposure from our counterparties, and is addressed in three layers: (i) first loss (USD 0.5 billion), (ii) mezzanine (USD 0.8 billion) and (iii) senior (USD 11 billion). The first loss element is retained by us and actively managed through normal credit procedures. The mezzanine layer was hedged by transferring the risk of default and counterparty credit spread movements to eligible employees in the form of PAF2 awards, as part of their deferred compensation granted in the annual compensation process.

We have purchased protection on the senior layer to hedge against the potential for future counterparty credit spread volatility. This was executed through a CDS, accounted for at fair value, with a third-party entity. We also have a credit support facility with this entity that requires us to provide funding to it in certain circumstances. Under the facility, we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us. The credit support facility is accounted for on an accrual basis. The transaction overall is a four-year transaction, but can be extended to nine years. We have the right to terminate the third-party transaction for certain reasons, including certain regulatory developments.

Oh man, if I could write like that. If I could do that*! It's from Credit Suisse's quarterly financials released today and it is magic. The first paragraph is about their PAF2 facility, which we've talked about it before, in which Credit Suisse bankers get paid in the form of their own counterparty credit exposure. If you lived in a world of pure economic decisionmaking you'd probably be like "yeah, that's great, eat their own cooking, align incentives, blah blah blah." I mean, I did.

But the second paragraph! I am not a doctor so I've probably got it wrong, but here is how I read it:

(1) CS (the bank, not its bankers) still has ~90% of senior credit risk on that thing (in addition to ~4% of first-loss risk which it manages using "normal credit procedures").

(2) It is, shall we say, a creepy risk: it is the credit risk on the "expected positive exposure" on some derivatives trades. That is, CS is currently in-the-money, or otherwise expects to end up in the money, on a bunch of trades, and those exposures are not collateralized by its counterparties, and it doesn't expect the in-the-moneyness to dissipate. This is not "someone owes us $11bn and we hope they'll pay it back"; this is "a lot of someones owe us an uncertain amount of money but it might be $11bn and if so we hope they pay it back."

(3) Anyway, they want to buy CDS on that creepy risk. That CDS is obviously very custom, being credit-enhanced (behind ~10% of first-loss and mezz tranches), composite (it's on a shifting amount of derivatives exposure), on a custom portfolio of names, etc.

(4) But they found a seller who was willing to write them such a weird CDS contract.

(5) BUT. But "we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us."

(6) What?

(7) I think that says "if our counterparty doesn't pay us when this derivative, which is in-the-money if our other counterparties don't pay us when their derivatives are in-the-money, is in-the-money, then we'll just pay ourselves ourselves."

(8) In exchange, though, the counterparty will assign the CDS to Credit Suisse, SO THAT'S NICE.

(9) So ... what?

The game is given away a little bit with "accounted for at fair value ... accounted for on an accrual basis." Credit Suisse has sold CDS to itself on its derivatives counterparties - if any money changes hands it will go from CS, to the CDS seller, back to CS, which may explain why it was able to find someone to write such a weird CDS contract.** If CS's other counterparties' spreads widen then Credit Suisse will have an offsetting gain on the CDS that it bought, but because of the accounting differences it will not have an offsetting, offsetting loss on the CDS (sorry, "credit support facility") that it sold. It has transformed a mark-to-market CVA exposure that would reduce its net income (and, thus, regulatory capital) if counterparty spreads widen, into an accrual thing that won't reduce capital until there are actual defaults on CS's actual derivatives.

Useful background reading on this is yesterday's Bloomberg article, which makes the good point that PAF2 - the thing where CS gives the mezz tranche of this exposure to its own employees - is, in addition to being the One True Way to motivate bank employees, also a capital arbitrage. Other, less creative banks have done similar deals in which they sell the mezzanine exposure to clients, rather than to their own bankers, and you could discuss amongst yourselves what incentives that creates, but the point is that those are not primarily economic transactions but are rather regulatory capital transactions.

Basically the arbitrage is that, due to regulators' different views about risk-weighting of assets depending on credit enhancements like these deals, the bank needs to hold less capital against a 90% senior + 4% first-loss exposure to this derivatives portfolio than it would against 94% of the entire portfolio. Thus Value Is Created, for the bank, and probably someone should be fretting about the homeowners. Lisa Pollack has wonderful, technical discussions here, here and here.

The Bloomberg article has the requisite academic-and-regulator fretting about how all of this regulatory arbitrage is a bad thing. I sort of shrug - if the capital treatment for the full portfolio is sensible, and the capital treatment for the actual tranching is different but also sensible, then tranching ends up with one of a set of sensible capital treatments while also creating a finer and more specific allocation of risks to people who want to bear customized risks. If the capital treatment for the tranching is not sensible, then that points to a bigger problem with capital treatment for credit-enhanced or AAA or whatever things, and regulators should just fix it rather than worry about banks exploiting it on one particular set of exposures.

But, yes, this regulatory arbitrage has to be at least a little bad; it's potentially destabilizing, and in any case resources devoted to gaming capital regulators are resources not devoted to curing cancer. On the other hand, man cannot live on bread and cancer cures alone. And I, at least, appreciate the capital arbitrages that led to this Credit Suisse deal. Because this deal is a work of art.

First Quarter 2012 Results [Credit Suisse]
Credit Suisse Bonus Bonds Lead Embrace of Relief Deals [BW]

* I mean, I sort of did that in a former life, but not at that level of mastery. If I could have done that, I'd still be in finance. Or in jail!

** Update. To be clear, I'm probably exaggerating by somewhere between "a smidge" and "way, way too much." Of course CS didn't literally write CDS to the counterparty with the same terms as the CDS the counterparty wrote to it. But what the disclosure says is that the counterparty wrote CDS to CS, and CS wrote a credit support facility where it would fund counterparty's CDS obligations under certain circumstances.

Call those certain circumstances {X}. If {X} is a large set then that sentence means "CS wrote CDS to itself"; if it's a very small set then it's just "CS paid a market rate for credit protection from a third party." There is a further constraint, which is that if {X} is "all circumstances in which counterparty might owe CS any money under the CDS" then it's certainly "CS wrote CDS to itself" but it's also the sort of trivially obvious thing that won't get favorable accounting or capital treatment. The game is having {X} be large enough that the counterparty feels like it's not writing an economic contract, but small enough that auditors and capital regulators think it is an economic contract. The name of that game is "regulatory arbitrage."

Further update.Here is a more sensible human saying similar things; he explains the collateral-posting mechanism in what seems likely to be the correct way and he ends up in the same place, viz., "Magic, isn't it?"